Every One Gets A Haircut?

The main talking point for many today is the ongoing tension between Greece and Germany, with the consequence being felt in the debt market and the inability of the euro to sustain even modest upticks. However, perhaps rather than the apparent differences, what is really going on is being driven by their similarities. Specifically the latest opinion polls seem very clear and in agreement. The majority of Germans do not want to bailout Greece and a majority of Greeks do not want foreign assistance. What does this mean?

It means the unthinkable has become thinkable: restructuring. The continued widening of spreads against Germany reflects this. Suppose, for example, the goal is to bring Greece’s debt/GDP ratio to 60%, as the Stability and Growth Pact mandates. In lieu of currency devaluation, many investors appear to be taking more seriously, debt deflation. All stake holders may have to take a hair cut and how the costs are distributed is what the European politics may determine.

Greece will have to lower its standard of living. Some reports suggest that Greece may be facing demands to raise the retirement age to 67 from 62 and abolish the two months bonus for government workers. Greece also faces a deep economic contraction and rising levels of unemployment. Countries, like Germany, who export goods to Greece may see weaker demand. Bond holders may have to take a hair cut. To reduce the debt/GDP level to 60 % requires cutting the debt in half. A 50% haircut is steep compared with other sovereign debt restructuring. The current 2-year Greek-German spread is consistent with about a 25% chance of a 50% haircut or about a 33% of a 40% haircut.

There seems to be a growing realization that the bond holders are primarily banks and much of the EU/IMF funds will eventually wind up in the banks’ vaults. Greece is really not being bailed out. At best it is being forced to boost its savings so it can service its debt, and lent money so it can service its debt. The backstop for Greece may really be another backstop for European banks.

Next month’s UK election continues to be a major talking point as well. On balance, the polls continue to point to a Labour-Lib-Dem coalition. On one hand, Labour seems more willing to agree to electoral reform than the Tories. On the other hand, Lib-Dem’s Clegg is insisting that if Labour actually comes in third in the popular vote, he could not accept Brown as Prime Minister. The third television debate is set for Thursday. The risk is that the attention the UK election is receiving is overshadowing a very important state election in Germany. North Rhine Westphalia goes to the polls on May 9th. The polls continue to show the governing CDU/FDP coalition losing its majority. If it were to lose its majority, Chancellor Merkel would lose her majority in the upper chamber of the German parliament. This would undermine her agenda, which includes cutting taxes.

This may in part be influencing the German government’s stance vis a vis Greece and it appeared that the French Finance Minister hinted at this yesterday as well. Merkel tried to justify support for Greece on the grounds that it is really about the euro: “We’re not doing this because we believe Greece needs help. We’re doing it because we’re interesting in the euro’s stability. We can’t idly stand by when our currency comes under threat.” Is the euro really under such a threat? The Bundesbank’s Weber, and a leading candidate to replace Trichet at the end of his term, said point blank that there is not credibility issue for the euro. While the euro has declined about 7% since the start of the year, it remains by the OECD’s measure of PPP is still more than 12% over-valued. A weaker euro is part of the solution for Europe, not part of the problem.